Credit Crisis Interview: Todd Sinai on Home Values

Don’t think of your house as an investment comparable to savings or a stock portfolio, says Wharton finance professor Todd Sinai. He is one of seven Wharton professors interviewed by Knowledge@Wharton for this special report on the credit crisis.

An edited transcript of the conversation follows.

Knowledge@Wharton: Homes have long been thought of as a rock-solid investment, the thing that always gained value and never let you down. And now, in the last decade or so, a lot of people seem to have started to look at their homes as investments — and not just speculators, but ordinary people who thought there was a huge value that they could tap in their homes. And we’ve seen that now they’re behaving like investments, like stocks, which sometimes go down and don’t always go up. Has the real estate market evolved or changed, or is this just part of a regular cycle that we see from time to time?

Sinai: Wow, you’re starting with a doozy of a question. There are a lot of answers to that. So, to take the last part first, the real estate has changed, but still, there’s a lot that is the same. So let’s start with the fact that you started with, that house values are behaving like stocks now, and they didn’t behave like stocks before, that they’re exhibiting more volatility now than they used to. I don’t think that’s really quite true.

So, what we’re seeing now that we haven’t seen in the past is actual declines in house prices — nominal house prices at the national level. We’ve seen actual declines in house prices at the local level before. If you owned a house in Boston that you bought in 1988, by 1992 you were underwater on your mortgage, even though you had put 20% down. So house prices have fallen before. The thing that they’ve done at the national level is they’ve fallen in real terms, and they’ve always gone up in nominal terms.

Well, back in the 1970s, and even the 1980s, when we had lots of inflation, it was easy for house prices to go up a lot in nominal terms but still be losing real money in real terms.

Knowledge@Wharton: In other words, the price went up, but when you factor in inflation, this is where you’re really losing value.

Sinai: Absolutely. So, comparing your house price to nothing happening, to keeping money under your mattress, is probably the wrong thing to do. Comparing it to what you could have made in some other investment is probably the right thing to do. And housing has dropped a lot in the past. So it’s evolved to a kind of asset.

Now, having said that, to think of houses as an investment, I think is somewhat different. And, I think it’s partly because, for people who are living in their house — it’s being used as a primary residence — there’s not a lot of investment value to it.

And what I mean by that is that I bought a condo in mid-town Manhattan. Let’s say I paid $500,000 for it in the mid-1990s, and it’s worth $1.5 million now. Well, if I sell that and I still want to live in mid-town Manhattan, I’m still out a million-five to buy another one. So, my investment has gone up a lot, but it just covers what I need to buy with it, which is a place to live.

And the difference between housing and the stock market is that when you sell the share of stock and it’s doubled in value or tripled in value, you can buy more stuff. If your house doubles or triples in value, you can buy the same amount of housing — unless you’re going to move somewhere else where houses’ prices didn’t rise quite as much.

So it’s a very different thing to think about in terms of an investment. And I think when people say that people are using it as an investment, what they mean is they’re using it as a line of credit.

Knowledge@Wharton: Now, we saw prices just soaring in the early and mid part of this decade. What was behind that?

Sinai: The rest of it is due to a couple of factors. About two-thirds of the run-up, on average, for the country appears to be due to, essentially, it’s cheaper to finance your house. And the way to think of that is that if you were to invest in stocks, by the time you went from 2000 to 2005, the kind of return or yield you would have gotten on the stocks would have gone down a lot.

It’s the same with bonds. Houses actually end up being priced a lot like bonds. When required yields are lower, bond prices go up. With houses, if the cost of your money, in terms of where else you could have invested it or the cost of borrowing for housing, goes way down, then the prices go up to compensate. Now, that’s about two-thirds of it. A third of it just seems to be what we call momentum — looking backwards and saying, “Hey, prices have gone up.” It’s going to go up in the future. And that’s sort of a behavioral or psychological, kind of bubble story.

Knowledge@Wharton: And part of it, I take it, is that when interest rates are low; a person of a given income can qualify for a larger mortgage. They have more money to spend. They can bid up prices.

Sinai: It’s hard to tell how much of it is that qualification mechanism, that people spend as much they’re allowed to spend, and how much of it is really people, in effect, behave like a really rational asset pricer would in the bond market. And I don’t think you can distinguish between those.

But, in essence, your intuition is right, which is, if I’m thinking of buying a $100,000 house, and the interest rate is about 10%, it’s going to take me, to finance the whole thing, $10,000 a year. If the interest rate drops to 5%, that’s $5, 000 a year, and if I’m willing to spend $10,000 a year, then I can pay for a $200,000 house. Well, a large chunk of that increased willingness to pay leads to bid-up house prices in markets where it’s hard to build housing, because people are competing with each other to get into those houses.

In markets where it’s not hard to build housing, that increased willingness to pay just means developers say, “Wow, profit!” And they come and build more houses, because now the value of the house, once they build it, is greater than the cost of construction. And that’s what we saw in South Florida. That’s what we saw in Phoenix. That’s what we saw in Las Vegas. That’s what we saw in Central California.

Knowledge@Wharton: One of the things you notice, if you drive around in suburbs around major cities, as you compare the newer neighborhoods to the older neighborhoods, the lots may be the same size, but the houses get bigger, and they’re more elaborate, and they have more stonework and all of these sorts of things. And I’m wondering to what extent is the housing market kind of a fashion industry that people just feel they need to have the house that has all these bells and whistles?

Sinai: I think there are changes in tastes for what we call the structure part of housing. If you were to look at what has really driven the growth in the house prices in these markets — what we call house prices, we mean the combination of the structure and the land that it’s built on — most of it, if you can decompose it, can be decomposed down to growth in the cost of the underlying land.

So the rapid rise in house prices, in LA or San Francisco and New York, was not so much that people are buying these fancier condos in New York, or fancier apartments in San Francisco, or fancier houses in LA; it’s that the cost of just getting a place in that market has gone up a lot.

Having said that, the people who can afford to get a place in those markets are also the people who like granite counter-tops and massive home theaters and lots of square footage and all the other things that go along with being a high-income household. They also have a Mercedes and BMWs in their garages, and all the other stuff.

So the kind of fancy housing goes along with the higher spending, but it’s not driving the higher spending. And I think, really, what’s driving the higher spending is that, basically, there are just a lot more rich people in the US than there ever used to be. Some of them were born here, and some came from other countries, but there are just a lot more people willing to spend a lot more money on housing, and there are only so many places that they want to live.

Knowledge@Wharton: Now, it’s long been government policy to encourage home ownership. We now have a rate that is somewhere in the high 60s, I believe. And I’m wondering whether this was something that helped feed this subprime mortgage problem.

Sinai: I don’t think government policy towards home ownership explicitly fed the subprime problem. I have really no idea about what’s implicit in your question, which is: did that lead to a degree of lack of regulation and oversight in the housing finance industry that led to the subprime problem?

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I think, in large part, the subprime problem came from the lending sector, banks and finance companies that were in a hunt for yield. They had capital they needed to put to work, and they needed to get yield. And you could take an abnormally low yield in traditional bonds, or you could put it into housing, and you could do it knowing that you were taking on risk. You might not have known exactly what the parameters of that risk were, but you knew that you were taking on risk, and it was still worth it, because then you could actually make a bit more money, or the same amount of money. I think whatever regulation the government had done, Wall Street would have found a way to circumvent it.

Knowledge@Wharton: So it was really a search for high-yield investments rather than the government saying, “You’ve got to go out and make sure you’re doing loans in poor communities” and all those sorts of rules that we’ve seen over the years.

Sinai: I think that the run-up in house prices that we have seen; if they were explicitly contained in poor communities, then you’d have an argument for that policy. Certainly, we think that the communities that have had more subprime lending have seen larger growth in the house prices. That has been a portion of the run-up. It has not been nearly all of the run-up in house prices. It explains a little bit of the differential; it can’t explain the entire differential between those communities.

So, I think the thing to keep in mind is that the traditionally poor communities are not the ones that have generated the bulk of the price growth. San Francisco is no longer poor. It is the rare poor person who can live in the San Francisco metropolitan area. And they had 200 some-odd percent house price increases over the last eight to nine years.

Knowledge@Wharton: Now, subprime mortgage is kind of a dirty word today. But as recently as a year ago, a lot of people were defending it, saying, “Well, look. Yes, a larger portion of them go bad than other types of mortgages. That’s expected.” But the whole impulse here is to make mortgages available and home ownership available to people who couldn’t get standard mortgages, as their credit is no good or their incomes are low or some sort of problem like that.

So, has this been a failed experiment to get money to those people, or is it something that just shouldn’t have taken place in the first place?

Sinai: Oh, I hope it’s not a failed experiment. I think this is a market that’s terrific. I think that the excesses and abuses…the jury is still out about what has actually happened here, and I think we need to wait a bit for the things to come in.

The problems that are happening, I think, are not because subprime is subprime — that is, that subprime has negative amortization, where you pay below market interest and your principal goes up. I don’t think that’s inherently a problem.

I don’t think adjustable-rate mortgages that turn into fixed-rate mortgages after a low teaser rate are inherently a problem. Those are all good things that borrowers should be able to have access to, and I think we actually have real evidence that credit markets get worse when you rule those things out. When you have no documentation of income, when you have people saying, “Yes, I’m living in the house” but they’re not actually living in the house, that’s when the model breaks down, because the investors need to be able to know what the actual risk of default is from the borrower.

And they need to be able to know that the borrower is actually living in the house, because, historically, if you’re living in the house, you have a much lower rate of default than if you’re an investor, who will default much more strategically — that is, if the house value drops below the loan amount. And so, for an investor to make a proper decision, they need actual, accurate information on that. And they were taking risk that they may or may not have known about, in that borrowers may not have been completely truthful; with of course, the complete consent of the mortgage originator to not actually check.

That’s a regulation problem. Borrowers need to be fully informed about the loans that they’re taking, and investors need to actually know exactly what the risk characteristics of the actual borrowers are. And so we have full information there. But the structure of adjustable-rate mortgages, or negative-amortization mortgages, those are all fine structures for people to be able to borrow through.

And the truth is that, for someone like me, I should have an adjustable-rate mortgage. It is less expensive, on average. I take interest-rate risk, but I have enough liquidity in my life that if interest rates go up, I can still afford to pay it out of cash flow. I don’t become illiquid. It’s like going to Las Vegas. Can I gamble in Las Vegas? Well, if I have the bankroll to back it, it’s okay. It’s my decision to take that gamble or not. And adjustable-rate mortgages are taking an interest-rate gamble.

It’s probably a bad match for someone who doesn’t have the resources to take that gamble, but it doesn’t mean that the product shouldn’t exist.

Knowledge@Wharton: Now, how should we ensure that the people who take on mortgages that have all sorts of features that are hard to understand are fully informed of what they’re doing? Do you need a license to get a mortgage? Or should you have to go through a seminar or read a pamphlet? Who should be responsible for delivering that kind of information?

Sinai: That’s an excellent question that I don’t have a good answer to. I think there are lots of possible answers to this. I think it is relatively straightforward to improve disclosure on these products. So if you go and take out a mortgage, you should get more information than just, “If the interest rate environment does not change, this is what your payments will be” — which is about the information that you get right now.

You can disclose to investors how much your cash flow payments could go up, how much they could fall; and historically, what are the odds of those things happening? So, better disclosure that’s mandated is probably a good thing. It certainly can’t hurt.

Knowledge@Wharton: Those are fairly basic things that you don’t have to be an economist or a financially sophisticated person to understand, that if interest rates rise to normal levels, from the sub-normal levels of the mid part of the decade, your monthly payment my double. And then you can figure, “Am I going to be able to pay that?”

Anyone can pretty much understand it, if it’s explained in a straightforward way, is that right?

Sinai: If the calculation is done for you, you can do it. A lot of these products — I have smart students at Wharton, and I would say that any of the students I’ve had, before taking a class, would not be able to figure out what their payments would be if their interest rate changed. That is not an easy calculation to do for a Wharton student; it is a harder calculation for…

Knowledge@Wharton: But it could be presented in a table or a chart.

Sinai: A figure or a chart — yeah, absolutely.

Knowledge@Wharton: In some graphic way that you could really understand it.

Sinai: But that’s only part of it. There’s a whole host of things that — do you need a license? Financial education clearly needs to be improved. There are a large bundle of things that probably need to be done to help people be better consumers in this market. That’s a combination of consumer protection and consumer education. But wiping out a whole bunch of financial products is probably not a good idea.

Knowledge@Wharton: To some extent the market seems to have handled that already. I gather that there aren’t a lot of sub-prime loans being issued right now.

Sinai: Hopefully they will return. There aren’t a lot of sub-prime loans being issued right now because the investors who bought the bonds in the end, the source of the capital, aren’t willing to invest until they understand what the risks are.

And one thing that sub-prime investors counted on when they invested in bundles of these underlying mortgages was that defaults would not be correlated among them all that much. That is, some might go bad because people lose their job and they default, but the whole thing en masse is not going to go into foreclosure.

And they’re discovering that they weren’t quite right about that.

And I think they don’t quite know how wrong they were, and it’s hard to figure out whether you should invest and feel comfortable investing until you have a sense of what that risk is. And so they’re waiting on the sidelines, and I expect at some point they’ll come back and this market will reemerge in some form because it’s a fairly efficient way of providing capital to the housing sector.

Knowledge@Wharton: Now there’s been a lot of talk in Washington and elsewhere of ways to help the homeowners who are in trouble over this. And they run across the board, from things like buying the mortgages from the investors who own them and writing them down and reissuing mortgages with fixed rates at lower rates. Others would postpone the resets that will raise payments to some future date. A whole basket of things have been proposed.

But you’ve written that there are dangers inherent in any kind of bailout. And I take it that one of the problems is that inevitably you’re going to favor one group over another. Is that right?

Sinai: Yeah absolutely. I think the fundamental issue, some people call it fairness or whatever is that if you bail out people ex-post, based off of the outcomes that they face, then you are favoring a group who often through choices that they made, ended up in a financially bad situation.

And the question you have to decide as a society is: Do you want to reward that group? For example, if you look at the data, there are lots of people who you could see could have taken out what we would a call a sub-prime mortgage, say a low adjustable rate for two years and a much higher fixed rate for the remaining 28 years. Many of those people chose not to. Some chose to. And when they chose to do it, they did it at a point where there’s a good chance they could not afford the payment when it jumped up.

A bail-out proposal, if you’re going to bail out the people who are in trouble, bails out the people who made the financially unwise choice and basically doesn’t give anything to the people who made the financially sound choice. This is because the financially sound people didn’t get into trouble.

As a society, you might still want to do that. You might want to say, “For the greater good of not having neighborhoods empty out because all these people have to leave their houses because they’ve been foreclosed upon, we’re going to bail them out even though it’s inequitable.” But it’s inequitable and you need to weigh that in.

Knowledge@Wharton: I gather also that the people who are in trouble are not evenly distributed around the country and in different income groups. There are certain geographical pockets and certain income pockets. Can you explain that?

Sinai: Not surprisingly, when you look at the proliferation of sub-prime mortgages, most of the dollars of sub-prime mortgages are in the markets where there are lots of dollars of housing to be financed. So if you look at California and New York, California alone has about 26% of the outstanding sub-prime mortgage debt.

And in large part, it’s because there are two factors. One is that housing was very expensive, so when you borrowed money, you borrowed a lot of it. And another is that housing was expensive for the people who wanted to get in, so taking mortgages that had favorable initial terms allowed you to get into a house that you otherwise would not have been able to buy.

And so even markets like Texas, which is a very, very large market — it ends up being fourth on the list in terms of dollars, because the houses there were just not very expensive. I think there’s a tendency for people to think of sub-prime as being an issue that was faced by poor people, because they couldn’t get credit before and they can get credit now — and that is not supported by the data. And I’ll get into that.

In the high house price growth markets — the San Francisco’s, etcetera — sub-prime usage goes all up and down the income distribution. In fact, it increases as you get higher up in the income distribution. And largely because the way that you got into the $1.2 million house that you really couldn’t afford rather than the $900, 000 that you could, with a 30-year fixed mortgage, is that you took out a sub-prime mortgage. And that enabled you to get to the house you wanted.

In the markets where we don’t see a lot of house price growth — Cleveland, Cincinnati, Detroit — sub-prime usage there is skewed to the bottom end of the distribution. People who would have been renters before get into the houses by taking out sub-prime mortgages.

Knowledge@Wharton: And I think that we should explain that one of the appeals to the sub-prime loan was its very low teaser rate. You might start out at 3% or some very low level. And your ability to qualify for the loan was based on that rate and whether you could support the payment that that rate would require.

And the question was sort of left unanswered about whether you could afford a rate that would be higher, sometime later. And that’s why you had both wealthy people who were trying to reach even further to get a bigger and bigger house taking out sub-prime loans, as well as what we tend to think of as the typical consumer which was the poorer person.

Sinai: Absolutely. And you can think of the following example, which is that you can imagine a 30-year fixed-rate mortgage at whatever the going rate was, could have carried a $1,000 a month payment on a $200,000 house. If you took out a teaser rate on that same house, you maybe would have had $800 a month, in terms of payment, initially, or even $700 a month. Or, if you could afford the $1,000 a month, then you could go and buy a $275,000 house instead of that $200,000 house. And your payment would remain the same, at least initially, but it would reset later.

Knowledge@Wharton: Now, some people who are looking for remedies to this problem, or ways to prevent a recurrence, are talking about changing the underwriting standards so that people would not qualify for a loan based solely on whether they can afford the teaser rate but would qualify on some longer-term view of whether they could afford rates that might be higher and the payments that might be higher. Do you think that there’s merit to this idea?

Sinai: Yes and no. So, for any mortgage that is implicitly guaranteed by the government — for example, a mortgage that would get bought by Fannie Mae or Freddie Mac, which are ostensibly independent, but everyone believes the government would step in to bail them out if they get into trouble. If they are mortgages that Fannie or Freddie could buy on the secondary market, then I think the government needs to mandate underwriting standards that make sure the mortgage is appropriate for the expected income of the borrower.

And yes, that would be for the entire stream of payments on the mortgage, relative to the entire stream of income, over time, of the borrower. If it’s not going to be bought by a government enterprise, then as long as there is full disclosure and understanding by the borrower and the end investor, I think the originator should just originate what they want.

We need to regulate and mandate complete disclosure and understanding. But if you have a borrower who wants a different set of mortgage terms and investors who are willing to take on that risk, then there is no reason that we shouldn’t allow that financial product to exist, and probably lots of good reasons that we should, because it’s a way of a lot of families getting access to credit that they otherwise would not have gotten access to.